BASIC FINANCE Joseph Vittek

BASIC FINANCE

Joseph Vittek Deputy Director Flight Transportation Lab M. 1. T.

July 11, 1972

Abstract

A discussion of the basic measures of corporate financial strength, and the sources of the information--the Balance Sheet, Income Statement, Funds Flow and Cash Flow, Financial Ratios.

Before an airline can buy new aircraft, it must be able to

pay for the plane. The carrier can do this by using its own

funds. However, few have enough cash on hand to purchase one

aircraft much less a fleet. Therefore, the carrier must rely

on outside sources for financial support.

What are the factors that a financial source investigates

before deciding to invest or not? The basic information on the

health of a carrier can be found from its balance sheet and

income statement. If this information is coupled with a know-

ledge ~f the carrier's working capital and cash flow statements,

an investor can compute some key financial ratios that will

allow him to determine his potential risks and rewards from

financing a carrier's operations.

ACCOUNTING PRINCIPLES

What are the basic indicators of corporate health, and how

are they constructed? This is the area of the accountant so a

basic knowledge of his techniques will be helpful.

Through the years, certain general rules or guides have

been developed that accountants follow in preparing financial

documents. These principles do not specify every detail of

accounting practice, so the accountant has a great deal of

~ freedom in tailoring his practices and procedures to the par-

ticular industry and company he serves. However, there are

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some generally accepted standards.

The Basic Accounting Conventions

Although the accountant does have a great deal of freedom

in how he sets up and keeps accounts, there are several widely

accepted conventions. The most important are:

1. Consistency - Once the accountant has decided how he

will set up the accounts and handle particular transactions, the

Consistency Convention requires him to handle all future events

of the same type in the same fashion. Thus, similar transactions

in different accounting periods can be compared, on a consistent

basis.

Since circumstances change, accounting procedures may be

altered to meet new developments. However, this is not done

often, and when it is, the changes must be throughly described

and documented.

2. Conservatism - This convention is often stated as

"Anticipate no profits and provide for all possible losses." If

there is an option in how a resource is to be evaluated, the

accountant will ordinarily select the method that yields the

lower value. For example, he would show the value of securities

held by the firm at the lower of cost or market value. Although

this procedure is often criticized as inconsistent, it is still

widely in use and is important.

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3. Materiality - often the recording of an event would

cost considerably more than the information obtained in the

process. Therefore, accountants will draw a line based on their

experience and common sense between what is important enough to

require close attention, and what can be considered immaterial

and handled in a less detailed way. For example, an accountant

would not require daily reports on how much fuel remains in the

tanks of the aircraft in the fleet, but would use some simpli

fying assumption such as, "fuel is considered used when it is

pumped from storage".

The Basic Accounting Concepts

In addition to the Accounting conventions, there are several

basic concepts that underlie the keeping of accounts:

1. Business Entity Concept - Accounts are kept for busi

nesses, and not for the people associated with them. The

accounts reflect how transactions affect the business. This is

true whether the business is a giant corporation or a sole

proprietorship, totally merged with the personal finances of the

owner. In the latter case, the law views both the business and

personal transactions of the individual as his own personal

property for which he is personally liable. However, the

accountant treats the two separately. If the owner takes five

dollars from the cash drawer to buy food, the accounts for the

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business show a five dollar decrease in cash.

Since a corporation has a totally separate legal existance,

corporate activities are easily distinguished from the personal

actions of the owners or operators. However, there may still be

areas of confusion. To keep tighter controls of activities, a

corporation may treat various aspects of its operations as

separate business entities and keep separate accounts. Or there

may be several distinct corporations linked by stock interests.

In this case, a "consolidated" accounting statement could be

prepared, treating the whole group as one business entity.

Because of these techniques it is sometimes difficult to separate

out the information needed about a particular part of the firm.

2. Going Concern Concept - Under normal circumstances,

accounting assumes that the business entity will exist for an

indefinite period into the future. This eliminates the need to

constantly compute the worth of the company as if it were to be

liquidated, and instead concentrate on measuring performance by

estimating the value of production. Market values of machinery

and resources acquired, but not yet consumed are ignored since

resale value is not important. Their value to the firm is through

the creation of future output.

3. Cost Concept - Since the Going Concern Concept elimi-

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nates the need to value the resources of a company at their

going market price, the books of the company will record their

worth at initial cost. This value is never changed to reflect

market influences, (unless the Conservatism Convention is applied

when market value is below cost). Therefore, the dollar amounts

on the books of business should not be confused with the actual

value of the company's holdings. Some resources such as cash or

securities that could rapidly be disposed of will have a book

value very close to market value. However, items such as land or

equipment may be shown at values considerably below their worth

in the market place.

The Cost Concept serves to remove subjective influences in

evaluating the company. Two people may disagree widely on the

value of a piece of property. By using original cost, a consis

tent measure is obtained.

4. The Money Measurement Concept - Closely allied to the

Cost Concept is the Money Measurement Concept -- accounting

records only include factors that can be expressed in monetary

terms. Thus, a large number of diverse aspects of the firm can

be reduced to a common denominator and added, subtracted or com

pared.

Since accounting records only reflect things that have

monetary value, they will not disclose factors that cannot be

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expressed in dollars. The accounts will not show potential

contracts, the health of a crucial officer or internal manage

ment conflicts.

5. The Dual-Aspect Concept - The tangible and intangible

resources of a business are its "assets". Claims against the

business and its assets are called "equities", perhaps because

they are often enforced in courts of Equity. The equities are

divided into the claims of creditors -- "Liabilities" and the

claims of the owners -- "Owners' Equity" (called Shareholders'

Equity in a Corporation). The claims of the creditors have first

priority, with the owners being entitled to everything that is

left. Since the creditors' and owners' claim all the assets and

since claims cannot exceed the assets, the Dual-Aspect Concept

can be stated as:

ASSETS = EQUITIES = LIABILITIES + OWNERS' EQUITY

The true implication of the concept is perhaps more clearly shown

by rewriting this equation as:

OWNERS' EQUITY = ASSETS - LIABILITIES

The owners are entitled to what is left of the assets after

creditors' claims are satisfied.

Since any change in assets must be accompanied by a similar

and offsetting change in the equities, the assets and equities

are said to "balance." This balance is shown by the "Balance

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Sheet".

THE BALANCE SHEET

The balance sheet is the basic accounting report of a

business entity showing the financial status of the firm at a

given point in time. Every accounting transaction can be reported

as a change of the balance sheet. Figure I shows the form of a

typical although simplified, balance sheet for a small corpora

tion. The categories are defined as follows:

Assets

Earlier, we defined an asset as being a tangible or intan

gible resource of a business. For an asset to qualify as a

balance sheet entity, it must also have value, be owned by the

business, and have been acquired at some measurable cost. Assets

are categorized as:

1. Current Assets - Used to designate cash and other

resources reasonably expected to be either consumed, sold or

converted to cash during the normal accounting period -- usually

one year. The most common items are:

Cash: Funds available for immediate disbursement without

restriction.

Marketable Securities: Investments which can be readily

sold and will be disposed of during the coming year. They are

normally the types of short-term investments used to earn

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co

-

FIGURE 1

TECH AIRWAYS INC.

Balance Sheet as of June 30, 1972

ASSETS EQUITIES

Accounts Receivable Inventory prepaid Expenses

Total Current Assets

Fixed Assets: Land, Buildings and

Equipment

Total Fixed Assets

Other Assets: Investments Intangibles

Total Assets

Accrued Expenses Deferred Income

Total Current Liabilities

Other Liabilities: Bonds Payable

Total Other Liabilities

Stockholders' Equity: Common Stock Retained Earnings Capi tal Surplus

Total Equities

interest on cash not immediately needed for business purposes.

Accounts Receivable: Money owned to the business and

expected to be collected. The money is u.suall", owed by customers,

but it could be o~ed by employees or others. Where a note or

other writing has been executed in conjunction with the trans

action, it would appear under a separate category -- Notes

Receivable.

Inventory: Inventory items are tangible personal property

which is either held for sale in the ordinary course of business

or is somewhere in the production process and will be converted

into such goods. For example, aircraft awaiting delivery or on

the production line would be intentory, as would stocks of sheet

metal or rivets. But if the manufacturer uses one of those planes

as a corporate aircraft, it is no longer an inventory item, but

a fixed asset since it is actually used by the business.

Prepaid Expenses: These are often intangible assests such

as insurance policies, which have limited life. Once paid, they

represent value to the company. Normally, the item will be

totally consumed within three to five years at most, and some

times sooner. An example of a prepaid expense that is tangible

would be heating oil purchased for the coming winter.

2. Fixed Assets - Fixed assets are tangible resources

with a relatively long life expectancy. These are usually

resources used in the production process such as land, buildings

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and equipment. Fixed assets (except land) are gradually reduced

in value through ware or obsolescence. However, they are still

shown on the books at their cost with a separate entry made to

show the depreciation or loss of value since acquisition. This

concept will be discussed in more detail in a later section.

Note that an asset which has a potentially long life that

is held for resale is not a fixed asset but an inventory item and

would be listed under current assets.

3. Other Assets - All other assets are placed in this

section. Two major categories are investments and intangible

assets. Depending on the policy of the firm, these items could

be account groupings on the balance sheet, but here we have

listed them as classes of Other Assets.

Investments: Long-term holdings of securities, deposits,

etc. that are not to be coverted back to cash within the year

(unlike Marketable Securities which will be converted).

Intangibles: Includes patents, copyrights, licenses or

goodwill. In keeping with our basic definition of an asset, they

must have value, be owned and have been acquired at a measurable

cost. Therefore, goodwill that a company builds up through its

own operations is not entered on the balance sheet. Only goodwill

acquired through the purchase of another firm can be listed.

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Eguities

The equities of a firm are of two types -- "Liabilities" and

"Owners' Equity." In a corporation, Owners' Equity is called

stockholders' Equity.

1. Current Liabilities - Like Current Assets, Current

Liabilities refer to short-term transactions. This includes

long-term liabilities that will mature in the coming year as well

as obligations arising from the operations of the business. The

major accounts are:

Accounts payable: The claims of suppliers, creditors and

others are recorded in this account. These claims are usually

unsecured. If there is a note or other written evidence of the

claim, it would be listed under "Notes payable" or a similarly

titled account.

Estimated Taxes: Since taxes can be a relatively large

account, they are listed separately. It is shown as an estimate

since the exact amount may not be known at the time the balance

sheet is prepared.

Accrued Expenses: This account represents obligations

incurred by the firm but not yet paid (such as wages owed for

work performed). If there is an invoice submitted, or other

tangible evidence of the debt, it would be listed under Accounts

payable instead of here.

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Deferred Income: If the company has received payments in

advance, it is under an obligation to perform its part of the

bargain or repay the advance. Therefore, such sums are shown as

a Current Liability until the obligation is fulfilled.

2. Other Liabilities - These are long-term liabilities of

the firm (such as bonds) which will not come due in the next

year.

3. Stockholders' Equity - All the resources left after the

liabilities are satisfied equal the Stockholders' Equity. This

is sometimes called the residual interest, since the owners only

get what remains after the interests of the creditors have been

covered.

Capital stock: In a corporation, the shares of ownership

have an initial value called the "stated value" that represents

either the price at which it was sold or a "par value" established

in advance, or some other value reasonably fixed by the board of

directors of the firm. The total represents the paid-in interest

of the owners. (This is not necessarily related to the market

value of the stock which is determined by owners selling their

interests to new owners on the open market.)

Retained Earnings: If the company has profitable operations,

it has "earnings". These are either paid out to shareholders as

dividends or retained by the company for corporate uses. The

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difference between the total earnings of a company from the date

of incorporation to the date of the balance sheet and all dividends

ever paid is shown in the retained earnings account. If this

difference is negative, it is called a "deficit".

Capital Surplus: Sometimes the Owners' Equity is changed

by transactions unrelated to the company's operations. Perhaps

a town interested in attracting new business donates land for a

site. The value of the land is shown in the Capital Surplus

Account.

EXAMPLE

Andy Aviator has established Tech Airways Inc. to operate an

air-taxi service. The corporation has authorized the issuance of

100,000 shares of common stock at a par value of $1 per share.

Only 10,000 shares have actually been issued, all purchased by

Andy for $10,000. Figure 2 shows the balance sheet at this time.

Andy's first step as president and general manager is to buy

a plane for $60,000. He uses $5,000 of the cash as a down pay

ment and finances the remaining $55,000 through a $5,000 short

term note and a long-term $50,000 mortgage on the aircraft.

Figure 3 shows the balance sheet after these transactions.

Since the remaining $5,000 cash is not sufficient to start

operations, Andy decides to issue bonds for $20,000 and issue

another 10,000 shares of stock. He finds a friend who is will-

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FIGURE 2

TECH AIRWAYS INC.

Balance Sheet as of June 30, 1972

ASSETS EQUITIES

Current Assets: Current Liabilities:

Fixed Assets: Other Liabilities:

Other Assets: Stockholders' Equity:

(ASSETS ($10,000) = EQUITIES ($10,000))

FIGURE 3

TECH AIRWAYS INC. fe-It, ,

Balance Sheet as of ~ 1972

ASSETS EQUITIES

Current Assets: -r ')',,"0 In"" 1\4t< $' ~ <a -I 'oil, .. 0 /fIfnfil~ ~uu - 'lo, ... ;j"'p(",,(:

Current Liabilities:

Cash

Fixed Assets:

Other Assets:

, s; tmJ

Total Current Assets ~

Total Assets

~'~m> (ASSETS ~ =

Other Liabilities:

stockholders's Equity:

Common Stock $10,000

TcIt./ Slodthole/u': 4"'" ffi", Il1n

Total Equities ~O,Oe6

dU;_

EQUITIES~

ing to pay $1.50 per share for 5,000 shares, and Andy himself

buys the other 5,000 at the same price. Andy uses $10,000 to

buy fuel, $5,000 for a two-year insurance policy, and $5,000 to

purchase a selection of snacks to be sold on board to passengers.

Andy invests the remainder of the new capital in government

short-term bonds since it is not presently needed to cover

operational costs. Figure 4 reflects the effects of these trans

actions on the balance sheet.

Tech airways is now ready to start operations. Pete pilot

is hired as chief pilot, and flys 5 flights carrying 15 passengers

over the next few weeks. Ten of the passengers pay cash for a

total of $5,000, and 5 charge their tickets to Diner's Press Cards

for $250. One of the passengers pays $50 for a return flight he

has not yet taken. In addition, pete sold $100 worth of snacks

for $200.

$300 worth of fuel is used during these operations, and

Pete's salary for the period is $250 which has not yet been paid.

(See Figures 5 and 6)

Tech Airways operates profitably. By June. of the following

year, its balance sheet looks like Figure 7.

Since there is a healthy cash balance, Tech Airways pays off

the $5,000 note. Andy also decides that the company should buy

out Avonic Airways, its only competitor for $25,000--$10,000 in

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FIGURE 4

TECH AIRWAYS INC. ~.Iy 9

Balance Sheet as of-J~ly 5~ 1972

ASSETS EQUITIES ------------------------------------------- -----------------------------------------------Current Assets: Current Liabilities:

Cash $ 5, 000 + '2o,,,"c t- fk,J., r Ir", If1If) /t:- S-Iock

M,,./(ej,Me S~C ur;fies I J, _ - f' 10, olJrJ ,/wl

Inventory (S.""ks) s; - - $' r,- rt' AMacl{,.

P.Hf4-I 'd CK/,t-uStS - Q 0;""0 1:' ;,.....~ -I~.t /0, (;Vf) - t IS; IJUD ?"i .41!~ f"'f"''''~ r; /II1't> - I' 0; 1Jr>~ (]",.~

Total Current Assets $5,999

1f f oJ i!V'" -Fixed Assets:

1 Airplane $60,000

Total Fixed Assets $60,000

Other Assets:

J> / /JI), we Total Assets $65,OQQ-

-; ;-;0, no (ASSETs... ($65,croO) =

Notes Payable $5,000


Other Liabilities:

Aircraft Mortgage $50,000 1J",.t. Owt~r.,.J.';'J $ 2." IO()O


stockholders' Equity: ,f 2.0, (WO

Common stock $~ (!4f,tAI JW/.fJ~ .r:; otJ1)

Total Stockholder Equity

Total Equities , IOD, !>DD

EQUITIES (~)

$5,000

.f;tS; ODO

$.JJl.,-6'O"5 J{J 100. out>

w)eo~

FIGURE 5

TECH AIRWAYS INC. J.Jy)'1

Balance Sheet as of J~ 1972

ASSETS EQUITIES

Current Assets: Cash

AU/ll<Mr; _-"M~f'rketable Securities ~cei"""/e Inventory (Snacks)

.fZS'D prepaid Expenses fuel insurance

T; 561> -f},.", It;:.",,, $ 5, 000 +~a> J~.ds

15,000 =Cod,d"7.D ~~ If,.t,,>

~ 'l,7fJO 5,000

Current Liabilities: Notes Payable $ 5,000

~~rM<td [?<J>- (tJ4/4IIJt) 2ro

])et(M&/ l~d>O<.. (l1dv4-o<~.t.S4k).ro

Total Current Assets , S,3eo

Total Current Liabilities $ ~O

Fixed Assets: Airplane $60,000

Total Fixed Assets $60,000

Other Assets:

TOtal Assets

., IDC,SS'D (ASSETS ($.lOQ,9e'O) =

Other Liabilities: Aircraft Mortgage $50,000 Bonds Outstanding 20,000


stockholders' Equity:

Cormnon Stock Capi tal Surplus i?eft;.;"e.< {a/lMi"S"

$20,000 5,000 " 1..~ Equity Total stockholder's

Total Equities

., /QD. S'S'o EQUITIES ($a99.BBO))

$ 70.000

if .tS'. 2£~ $ ;;j§,ee~

., 100. S'S'o $~.-oOB-

ASSETS

Current Assets: Cash Marketable Securities Accounts Receivable Inventory (Snacks) prepaid Expenses

fuel insurance


Fixed Assets: Airplane

Total Fixed Assets

Other Assets:

Total Assets

FIGURE 6

TECH AIRWAYS INC.

Balance Sheet as of July 21, 1972

$ 5,700 15,000

250 4,900

9,700 5,000

$60,000

$ 40,550

$ 60,000

$100,550

EQUITIES

Current Liabilities: Notes Payable $ Accrued Expenses Deferred Income

5,000 250

50


Other Liabilities: Aircraft Mortgage $50,000 Bonds Outstanding 20,000


Stockholders' Equity:

Common Stock Retained Earnings Capi tal Surplus

20,000 250

5,000

Total Stockholder's Equity

TOtal Equity

(ASSETS ($100,550) = EQUITIES ($100,550))

$ 5,300

$ 70,000

$ 25,250

$100,550

IV 0

FIGURE 7

TECH AIRWAYS INC.

Balance Sheet as of June I, 1973

ASSETS EQUITIES

Current Assets: Cash $ 74,500 Marketable Securities 15,000 Accounts Receivable 25,000 Inventory 5,000 Prepaid Expenses

fuel 20,000 insurance 5,000

Total CurrentAssets $144,500

Fixed Assets:

Airplane 60,000

Total Fixed Assets $ 60,000

Other Assets:

Total Assets $204,500

(ASSETS ($204,500) =

Current Liabilities: Notes payable $5,000 Accrued Expenses 2,000 Deferred Income 2,500


Other Liabilities:

Aircraft Mortgage $50,000 Bonds outstanding 20,000


Stockholder~' Equity: Common stock $ 20,000 Retained Earnings 100,000 Capital Surplus 5,000

Total stockholders Equity

Total Equities

EQUITIES ($204,500)

$ 9,500

$ 70,000

$125,000

$204,500

cash and $15,000 in stock at the stated par value of $1.00 per

share. Avonic has assets of 1 airplane worth $10,000 and a

$10,000 hanger. The extra $5,000 paid is for the goodwill Avonic

has gained by its record of service (See Figure 8).

Tech Airways, Inc. still looks profitable. with the end of

the year approaching, Andy estimates Tech Airway's tax liability,

based on projected operations and $6,000 depreciation on the

first aircraft. The short-term bonds are sold to increase cash.

Since a year of the prepaid insurance has been used up, its

value is decreased on the balance sheet. Since prospects for

the company are still bright, a $1 per share dividend is paid to

build stockholder confidence. (See Figure 9).

Because of his huge success, Andy decides he wants to become

a regularly scheduled interstate carrier and applys and receives

a Civil Aeronautics Board Certificate of Public Convenience and

Necessity. If Andy receives the certificate he will have to

comply with CAB reporting requirements. Figure 10 shows the

balance sheet accounts used by the Board and published in Title

14, Part 241 of the Code of Federal Regulations (CFR). The

details of this document can be found in the CFR where each

Account Grouping and each Account is described in great detail.

Figure 11 shows a typical Balance Sheet for an airline, as

published in its annual report. Although it follows the C.A.B.

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N N

FIGURE 8

TECH AIRWAYS INC. J"u.t<e IS"

Balance Sheet as of .:tIme "1. 1973

ASSETS EQUITIES

Current Assets: Cash Marketable Securities Accounts Receivable Inventory Prepaid Expenses

fuel insurance


Fixed Assets:

Airplane Ih/t/'l .... e ~au

Total Fixed Assets

other Assets:

Total Assets

20.000 5.000

$60.000 /0. ~tJ

'/J~.~oo $].41. sea

/0, no ,f 80. IJr)D

$ I'jQ,886

IS, no ---~ :; If. S {)'O

$~O Q ;. If, ! tro

(ASSETS (~) =

Current Liabilities: No1ses payai31e $ §, 000 Accrued Expense 2.000 Deferred Income 2.500


other Liabilities:

Aircraft Mortgage $50.000 Bonds outstanding 20.000


Stockholders' Equity:,t]S'.-, Common Stock $ 28.000 Retained Earnings 100.000 Capital Surplus 5.000

Total Stockholders Equity

Total Equities

Q ~ If, S" ,,0

EQUITIES (~;smJ1)

$ 70.000

~ lifo. ".-0

$ .. 25.00-0 .¥' ~11f) S' IJ'O

$~iSO"O

FIGURE 9

TECH AIRWAYS INC. 10

Balance Sheet as of June.-J-5'", 1973

ASSETS

Current Assets: -;- '11; MD jl!/fIft S~eM.:A.. Cash $59,500 -/J$,c"" ()i",'dAA ~fi~aH~"k~e~te;a:tl"'~lbee-9Seeee'=!lt:l:rl:"ii:'i:t~i:'l!!e~sr--:l~5;-,,.,0&0&0&- = ~ f, S"., c...~ Accounts Receivable, 25,000 Inventory 5,000 Prepaid Expense

Fuel Insurance

TOtal Current Assets

Fixed Assets: Airplane(De,wuc,,;r.,;, f,,_) Airplane Hanger

Total Fixed Assets

Other Assets: Goodwill

20,000 ",06012",,0

"{'f, opr>

$68,888 10,000 10,000

$ 5,000

,f 91,(7fTV $129,506

IY '/ f, I"'" $80,Oae

EQUITIES

Current Liabilities: Accrued Expenses Deferred Income (,ofi ... ",'iu -r /Ioflu

$ 2,000 2,500

" I( C I ttC"f)


Other Liabilities: Aircraft Mortgage Bonds Outstanding

$50,000 20,000


Stockholders' Equity: Common Stock $ 35,000

$

$ 70,000

Retained Earnings ±ef}-;-et)t) IY 1'".:>0

Total Other Assets

Total Assets

$ 5,000

$' 171, eM $ ft4';-500-

, nl, (J#J

(ASSETS ($214,506) =

Capital Surplus 5,000

Total Stockholders' Equity

Total Equities .f'I7I,_

EQUITIES ($~14,500»)

II ,6, rc-v $1-49,G09-

4' 111, """" $214,50Q.

FtGURE 10

-Curren; ~cts:

Title 14-Chapter iI

BALANCE SHEET CLASSIFICATIONS

Section 3-Chart of Balance Sheet Accounts

NaOle of accoup.t

C ~811 •• ___ • _ ••••• _ ••• ____ • ___________________ • _______________________ • _____ • ______ -_.-Sj)('ci:lj d~'posits ___ •• __ ._. ____________________________________________ n_. ___________ _ "t' nit ~,d 8t rites Government securltics _________________________________ ••• ------. -_. ---ulllrr t ..... rupor:1J'y c,'lsh inv('~tmclll5 ____________ • ________________________ ••••••• _____ e. .... !; ~OllnlS rcc~ i~3 hl,,-v,S. Government. _______________________ •••• ____ ".-_. _ •. - .• _ •• A(,COlllll s reeci vu bl('-forcil:1l {!O vrrnm{mts ______________ .. __ 0_ ."' ________ -------- -- .•• .... CC'Ollnt S recei V:l b l{'-S""ncrtl I trll mc_. ___ ._ •.•• __ . ___ •••• _ • __ •••••• _._ ••••• _ .. --.-.• - •• X 0; ~s :J.lld .:Icconnts rCelli ... ,\ blc-9.3sociated com pnnles. __ ••• _._. __ •• _ ••••••••••. ______ _ X "rell oud acconnts r(l~~lv:J.hlc-compo.ny personneL_. __ •• _ ••• _. __ •••••••• ___ • ___ • ___ • :\ Me~ :md .:Icco\m.s r(':(',(Ji vnblc--other _____ • _____________ •• _. __ ••• _ •••••••••• _________ _ Rnrrvt' for unoollcctlhlc ilccounts •••••• _____________________ •• .-.----•• -.--------- .--}' I idlt, eQl1lpmcnt (lxpend:lble parts._. ___________ • _________ • __ • __ ••• -.--------••• - --.-Oh~olf'sc(>n~~ ond deteriomtion resdvos-expendD.b!e parts_. _____ • ____ ._ ••• ___ • __ •••• _ ). [i~~{' l!'\nCOllS roll tnl.:lls an d 511ppiles_ ••••••• _______________ ._. ___ ••••• __ ••••••••••••• Stort-tHlU pr(>pn,yment8_. ___ •• _ ••• _. _____ •••• _._ •••• ___ ••• __ ·····_·.-••••••••••• -.-•• Of Il('r cnrrf'nt flSSl'ts _____________ • __ ._ ••••••••••••••••••••• __ •••••• __ •••••••••••••••••

lnvf'~:n'um(s and special funds: InV('SlnlcnlS In associated compo.niM ••• u •• n •••••••••• _._. ___ ••••••• _._ •• _ ....... _._.

I nl"estJnents 1.1\ 8ubsldL'lry cOlnpnnlt>6._ •• _._ ••••••••••••• ____ ._. __ •••••••••••••••• Inv('Suuents In other associated companles •• _ •• _ •••• _. __ • __ • ___ ._ ••••••••••••• ___ _

~ tb~~nj~~';~~~~~~~~~8°:etc~V:~~J::-::.:::::::::::::::::::::::::::::::::::::::::::::::: ::: .special f llnds--selt·iIl5UI'alloo _______ •• __ ••• _ ••••• __ ._._. ___ • _____ • __ ---•••• -.-••••••••••••• Special !:mds--othe-r ____ ••• _ •••••••••• _ •• __ ._ •• _. __ • _________ • __ ••• _ ••••••••••••••••••••

part 241

General elassltlClltlon

HlIO 1030 1110 ttl(! 1220 12;JU 1240 I:lf,{! 12GC 1::80 121;0 1310 I:iIl 1::130 1410 1<" lIno 1610.1 1510.2 10" -'04<) '550

1600-1700 ptopen y Ulld equipment ___ • __ •••• __ •••• _.·._· ______ ·_··················_ •••••• ----.~ 1--.----

A ir!rami's. _. _________ ._ •••• _ ••••• -•• ' ---------.---.-----•••••••••••• -.-••••••••••• - •• _I..i r('Tn r i l'ngillc.'! _ •• _. _____ ._ •••••••• _._. ____ •• __ •• ______ --•• --.---••• - ••••••• - •••••••• _"-ira:l.it propcUC'(S _____________ ••• _. ____ ._._ •• _____ • ___ •• __ ·_··· •••••••••••••••••••••• Aircrn,(t eomru IlniC!ltiOn.~ and navigattono.l equipment_ -.-••••••••••••••• -.-••••••••• -:'1\ :":;c(' lbncOlls flight f',qllipment ___ • _ •• ---•••••• -.--.-.-••• --••••• -•••••••••••••••••••• I~:l'roVt'm('nts te 1C':>$('d 1llgbt equlpment_ •• ______ ._._ •••••••••••••••••••••• _ ••••••• _. F:.Jt:ht C(lulpmcnt rotnble P:J.rts nod IlSsembllos. ___ •••••••••••••••••••••••••••••• _. __ _

.It. irframo \>..'\rts rind fI."Sem blies_. ___ e __ • ___ ._ •••••••••••••• •••••••• __ ••• __ ··_·· ___ _

A iraMt p,n[!:ina ,parts nnd ossern bUes ____ ._ •••••••••••••••••• - •••• - •• -.-.---.-.----Otbcr p,\rts nod ossem hlics_ ••• _ •• _______ •• ____ ··············_·· ___ • __ • _____ --.- ••

F!:;;:ht cqltiPment ___ •••••• __ ••••••••••• _________ •••••• · ____ ··.---------.-•• ---.--.-•• --.1\ ~~,'rvc for de Dn'c1a t1on-olrrramrs •• ~ ____ ._ •••• _ •• _ •• _·_··· ___ ---- ---.-------.-------Rr~"rve for depro::ciation--a.ireraft cDl!ine-s •• _ ••••••••••••••••• ________________ • ---.- _a. !: <'serve lor de-pr(>ciation-aircralt propellers •••• -••••••••• --------•• - •• ----- ........ .. Reserve for dcpreclntion-flircrllft communicu.tion nod navflJ8.t1onal equipment. --•••• ReserV{' for ::I.epreciation-miscellaueGus mgbt CQuipment ••• _________ • ____________ ••• _ Resrr.e for u(lprcclatloo-improvcme.ut.s to le:lsed 6jp:bt equlpment. _________ • ___ • __ ._ Reserve for deprrciatlon-fiir:-ht equipment rotable parts nDd assemblles •••• _ •• _ ...... .

Airfram(l parts and Rssembll CS- _______ ••••••••••••• _ ••••• __ ._._ •• _ ••• _. __ ._ •••••••

~~~!~~ner~i~;!~~~b~~~.~~-~~:=::::::::::::::::::::::::::::::::::::::::::::: .P. eservc (or oejlrceia tion-fllgbt equl pOlent_._._. -•••••••••••• -------~----.---.-.---.-"}'lJght equipmr.n t airworthiness rescrvcs. ____ ._ •••••••••••••••• ____________ ···_···_·· P::'ss"nger ~ervice equipment __ ._ ••••• e. ____ ._._ ••• _ •• _.··_·· __ • ____ ~·····-··-··-···-· Hotel, rest:mTl\nt nnd food service equlpment •• ______ ._ •• _____ ._ ••• _______ ._ ••• _._ ••• R::.;:n p fl1 ni pment __ • __ • ______ •••• __ ._ •••• _____ • ___ ._ •• _ •••••••••• _______ -------•• - ••• Cummun:cation an d meteoroJo~lcal eqnlproenL ____ ._._. __ •• _. ____ • _____ • ____ • ___ -- --:. bintCDnnce and eng:inp.erin!; cq III prnen t ••• __ • ___ •••••• _____ • _____ • ____ • __ ·_· •• -- --•• :iurfaCfl transport vehicles and ~Qulomellt. -•• ------.-••• -.---.----------••• ---.---•• -'F::rniturll, .fixtures and o(f:re oqulllmcnt __ ••• ____ ._ •••••• ~.···· ___________ ••• _______ _ S !ern ~c :l!,d (]l~trl~u tlon e(jlliplllCll t_ -.-.-•••••• --• .,. •• --•••••••••• -•• ------.~---------).1 ; ~"(' lbneous gronnd c'l!li pment._. ____ •••••••••• ••••••••••••••••• ______ • ________ • .--Bu~ id i:lgs and othe, i mprovcmen LS. ____ ._ ••••••• ___ ·_·· .... ••••••••• __________________ _

').1: nin tem:.nco hulldin!l"s and i m'roverocnts. _____ ••••••••••••••• _ •• _._ •• ___ • ____ _ Othrr bllildln!!s and improvements_ ••• __ • __________ ••••••••••••••••• _________ ----

G roun d property and cqniproenL __ ~._ ••••• -••• :------.-••• -•••••••••• -.--------.----. Heserve for de:;Jtcc:i?tlon-f1nss~ger service equlpment-._ •••••••••••• _._. ___________ • Reserve for depreciation-hotel, restaurant and rood service eQulpmr.nL _____________ _ .Re.serve for depreclation-rnm P eq ulpment. ______ ••••• _._ ••••••• ___ • ________________ _ :::::~scrve lor depreelabon-communlcation and mMeorolo!l:lcnl eQulpment-•••• __ • ____ _ R",erve for dcprec!ntion-maintenanee and engineering equlpment. ____________ • ___ •• Reserve for depreclation--t;llrface transport vebicles nnd eQulpmcnL,.... _________ •••• Res'!lvC for depreclation-furnltnre, tb:tuTe1 and omea E'QwpmenL_ ••• ___ •• _ ••• __ ._. Re~crve for d!lDreciation-storoge and dlst.ributlon equlpment _____ • __ •••• _._ •• ___ •

. P.~scrve [or deprneiaUon-tn1sceUD.n~u.s ground equlpment... ____________ •

i::.ec footnotes at end of tables.

Operating Nonopern'" IIIIl.

1601 1602 160' 10'" 1606 lOU7 HillS

lInus. ,. I]GOf.,.5 IHiiI~_g

1609 IGIl 1612 1613 1614 1616 1617 1618

11618, ,. I 1(11~.1i 1 1611i.9

1619 11629

II);JO J6:.S1 Jf>32 . Ij;':~3

1(;34

"'" 1036 1037 If03:) 1640 lti .. O.l 164.0,9 1649 16.'i0 11W1

'65' 16li3 16M '1i55 ,.,. "57 '6M

1701 1702 1703 1104 1706 )707 liOS

1)708.1 11708..5 11708,'

1109 1711 1712 1713 1714 1116 1711 17IS

Jl718.1 Ilil.!' • .5 1 171~. 9

I';ll! J I72!}

17all 17U 1732 li3a lia4 IT.55 1736 1i37 li3li 17'" 1740.1 1740. 9 17,,9 17W 1751 Wi:.! 1763

"" 171i~ 1756 1767

''''

Par' 241 Title 14-Chapter II

BALANCE SHEET CLASSIFICATIONS-Contlnued Section 3-Chart of Balance Sheet Accounts-Continuod

Name 01 account

Deft.m'<l cllno::r..!: i)'II ;!"-t crm prcraymen 1:3 __ •••••••• ~ •• _ ••• _ •••• __ ._ •••••• _ •••••••• _ •• _____ • __ ••• _____ • U oVl'lopmrntn and preoperattng costs_._ •••••••• __ •••••••• _. ___ •• ___ • _____ •• __ _ U nnmortitrd discount nnd orpcnse on deb~. __ ••• _ •••••••••• __ ••• _. ______ • ___ ._:---:· P DRmorti;:cd carll,al stock exponse. __ ._. __ ._ •••••••••••••••••••••• ___ ._._ •• _._ •• ---.-oropr::rty nCflulsltloD IIdjuRtmen t __ •• _ •••••• _ •••••••••••••••• __ •••• __ ••• __ ._:::.: o tlw,r In lnnd blr!l ___ ._ •••• _._._ •••••••••••• _ •••••••••••••••••••••••• - •••••••••• -.-.-.-

Currc;:~rlll:1~~~~~f~~~ cllnrges ____ •••••••••••• -•••• -••••••• - •••••••••••••••••• - -•••• ------

tN~[~I~~f~~fd~&~~~~.~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~:::::: otf!~ nnlll!.coounts pnyable--i1Ssoclated oampan.JOS" •••• M •• _ •• ______ ~ __ ~ ___ • ____ :--·:

~m~;fu~~~~~J~~;~~rf:f~1~~~~~~~~~~~~~~~~~~~~~~~~m~~~~~~~~~~~~~~~~~~~~!!!~~ gl\t':lrnf'l1 f.r:)n~port.'lUoo tcv!lnue. __ ._. __ ••••• ___ ._ •• __ ._ ••• ___ • ___ ••• __ •• _ •• __ _

NO'Ilm~~);:~lciuJ;~~~l~::~IlIUCS-.---.----.-•••• -•••• MM •••• _ •••• _._ •• _._ •• __ ._ ••• ___ •• __ ::::::

~JI~;-~~~lr~r:\i,;;·ci~ied·c;,~rmnj;;::::::::::::::::::::::::::::::::::::::::::::::::: Ad"anec~ (rOM non transport dlvlslons •••••••••••••••••••••• ________ • __ • _______ • PC11s!on II:)hll1f 'j ____ •• ~ ••• ___ ••••••••••••••• _ •••••••••••••• ___ • ______ ._. __ ..... _.:::::: CAmp:m'j stork [lUrchR..~e rlan Ua.blUty •••••••••• _ •••••••••• ___ • ___ ••• ______ ••••

DeJf'~~Jrc~~~n?:rant Uabtl!.t105. __ ••••••••••••••••••• _ •• _._ •••• _ •• _. ___ • __ ._._ •••••• ::::::

Un:)morti1.eo premll1m on dllbt ••••• _ •••• _ •• _. __ ••• _ •• ____ •• ____ ._. ________ ._ •• _____ _ Der~rr~d Federnllncoroo t..'lxe~ __ ••••••••• ___ • __ .~_ •• __ •• _ •• ••• __ ._._ •• __ •• _. __ • _

. w,~~~\~~~;;:;;~~~;;;;~~;;~;;;~~~~~;;;;;~~~;;;;;;;;;;;;;;;;;;;::;:::;~~:~!~ Caplb! SUlek subseriboo [lnd un1ssued. ___ ._ •••••••••••• _ ••• _ •••••••••••••••••• ::::::

:tb~\~~i1~;~~~:~~i.~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~m~~~~~m~mm~~ bPpropriRtlons or rEltamed ean11ngs ._. ____ ._ •• ______ •• _______ •• _ •••••••••••••••••

T~!fs~Ps~~~.~~:~.~~.~~~~~::::::::::::::::::::::::::::::::::::::::::::::::::

Operating Nonoperat .. 109

'660 1660_1 1600.9 1689 1679

'''''

nno 17G11., J 1760.~ 118fJ In' 17811

General olasslfl.cat1Oa

182Q , ... IB4() 1850 1870 18'" '800

2010 2IJ2IJ 2030 "' .. ""I) 2110 2120 2131 2t:1G 214D 21r;G 2161)

" .. 2211) 2Z4D 22" 2260

'"'" '290

"'" " .. "" "" 23911

23'"

"'" 2860 OS .. 2800.1 2890.1 2890.5 2590.' 2930 29<11 2I11III

t Prescribed for Group II and Oroup III air carriera only. l At tbe option of the air carrier tbeseacc:ounts may be assigned numbers 2629 and 2729 respectively roraccountIDg -- ' , NOTE: Digits to r1gbt of declma!s and ltalic1zed codes cstabllshod COr OAB control purposes only.

{ER-327. 26 F.R_ 4222, May 16. 1961 as amend.ed. by ERo--425. 30 F.R. '145. Jan.. 23. 1965: ER-546.83 F.R. 18696, Dec. 18. 19681

,

k r

Balance Sheet Oecember 31, 19$8 whh comparatlw IJgureI for 1987

Assala

Current 8889IS: Cash

United Slales GOVfIrnment and olher sec:urltles , Accounts receivable:

United Stales Government

Airline IraHlc , Qlnar, net _

Total accounts recelvlible • Spare parts and supplies, at average cosl.

Prepaid expenses. .. • • • Total current ElS$ets •

Inve:;tments and special lunda:

Advance payments on equipment pUrchase contracla (note 5) , Investment in subsidiaries and afliUales, at coal.

Other Investments and deposits. . . . • Total imreslments snd spacial wl\ds

Property and equipment, at cOst (note 1):

Flight equipment . . • , . • , Less accumulated depreciation

Flight equipment, net .

Other property and equipment • • less accumulated depreciation

Other property and equipment, nat. Cor.slNclion In progress • • , •

Net property and equipment

Cere,'red charges:

C::Ontrlbulion to the development of supersonic a:reraft, nel of amortization, $600,000

OIM, •. ,.",. Total deterred ch.arllaa. • ,

1088 1967

• 17,063,705 $ 12,463,157

2,019,632 16,766,068

5,268,613 6,431,548

14.405,401 11,123,574

2,564,214 22,238,228

11,602,801 8,608,378

3,014,443 928,766

55,938,809 58.742.399

14,439,276 32,899,273

3,984,760 3,540,310

2,010,427 1~99,558

20,434,463 37,839,141

323,554,928 208,117,681

58.690,271 37,984,497

264,864,651 170,753,184

47,420.872 29,012,781

13,593,176 10,836,234

33,827,496 18,176,547

935,558 5,"5,7'2

299,627,711 194,045,443

2,400,000

'.125,935 504,250

3,525,935 604,250

$379,526,918 $291 ,231 ~33

FIGURE 11

Uabilitiea and Stockholder.' EquIty

Current UabUltles:

Long-term debt, portion due within one year,

Accounts payable:

General Airline tralfic .

Transportatlon taxes and payroll deductions

TOlal accounts payable. Accrued liabilities,

Federal Income tal«lS

Unearned transportation revenUQ Total current liabilities •

Long-term debt, leB9 portion due within one year (note 2)

Reserves for overhaul of flight equipment, net .

Deferred Income taxes, Unamortized investment tax crad1ts (note 3). ,

Other deferred credits and non-current lIabillUea •

Stockholders' equity:

Common stock of $0.50 par value per share,

Authorized 15,000,000 shares: issued 10,050,867 shares, 1968; 10,015,901 shares, 1967 (noles 2 and 4)

Capital In excess of par value, • ,

Retained earnings (note 2). . . . Total slockholders' eqUity •

1968

$ 22,694,131

10,532,205

8,384,589

2,831.582

21.748.376

5,259,556 690,635

1,385,399 51,778,097

219,832,298

8,607,338 10,340,723

9,737,975

1,400,862

5,025,434 19,2<12,794

53,401,397

",629,625

$379,526,918

1967

S 9,131,722

11,584.054 7,491,016

1.499.621

20.574.691

4,278,505

486,549 785,320

35258,767

151,285,390

7,395.223

6,639,408

",061,076

1,467,793

5,007,953

18.848,260

~137,353

78,143,566

5291.231 ,233

classifications, the accounts have been condensed for ease of

reading by the stockholders.

THE INCOME STATEMENT

Before the Income Statement can be explained, a few more

accounting concepts must be mentioned.

The Accounting Period

The Balance Sheet reflects the status of a business at a

point in time. Balance Sheets are prepared on a periodic basis,

usually once per year. This is called the Accounting Period.

The Income Statement reports flows during the Accounting Period

rather than status at a point in time. Since management needs

information updated more frequently than annually, there may be

"interim" reports prepared at the required time intervals.

The Accrual Concept

Income is associated with a change in Stockholders' Equity

and not necessarily with changes in the cash account of the

business. In our earlier example, one of the transactions was

the sale of $100 worth of snacks for $200. Since the business

did not incur additional liability by the sale, the changes in

assets must be balanced by changes in the stockholders' Equity.

When the Cash Account is increased by $200, stockholders' Equity

is increased by the same amount. Likewise, stockholders' Equity

- 26 -

is decreased by $100 to offset the removal of $100 worth of goods

from the Inventory Account.

Any increase in the Stockholders' Equity from the operation

of the business is called "revenue." Any decrease is an "expense".

"Income" is the excess of revenue over expenses. If expenses are

greater than revenue there is a "loss". The sale of the snacks

thus represented $200 of revenue, $100 worth of expenses and $100

income. The cash change and the income are not the same.

1. Expense vs. Expenditure - An Expenditure occurs when an

asset is obtained either by the payment of cash, by the exchange

of another asset or by the assumption of an additional liability.

An Expense arises when an asset is used up and reflects a corres

ponging decrease in Stockholders' Equity. When $5,000 cash is

used to purchase an inventory of snacks, there is an "Expenditure"

of one asset for another cash for inventory. There is no

"Expense" since there is no change in equity. When $100 worth of

snacks are removed from inventory, there is no "Expenditure"

since no new asset is acquired. However, there is an "Expense"

since the decrease in assets must be reflected by a decrease in

Stockholders' Equity Account.

2. Revenue vs. Receipts - A "Revenue" arises when Stock

holders' Equity increases. A "Receipt" occurs when one asset is

received in place of another. When an air ticket is sold on

- 27 - ~JD

credit, Accounts Receivable are increased. This is a "Revenue"

since stockholders' Equity is increased by a corresponding

amount. When the obligation is paid, there is a "Receipt" but

no "Revenue" since equity stays the same. The only transaction

is an increase in Cash offset by a decrease in Accounts payable.

The Accrual Concept holds that income is measured as the

difference between revenues and expenses and not between receipts

and expenditures.

The Realization Concept

The Realization Concept is closely connected with the

Actual Concept. Broadly stated, a revenue is recognized when it

is realized, that is when the product is delivered or the service

performed. The revenue and expense accounts are updated, not

when the contract is signed or the goods manufactured, but when

the actual transfer of value takes place.

Since the Accrual Concept requires revenues and expenses to

be compared, expenses are recognized in the same accounting

period that the revenue arises. (The Matching principle) Thus,

the costs of manufacturing an item for inventor~ are not expenses

until the item is sold. They are then recorded as "Cost of Goods

Sold. "

Some expenses cannot be connected to a particular revenue

transaction. These are entered into the accounts during the

- 28 -

period when they are incurred--which is not necessarily when

they are actually paid for.

Figures 12 and 13 demonstrate these principles. In the

first transaction, goods manufactured in January are sold on

credit in February, and actually paid for in March. Following

the principles outlined, all bookkeeping entries are made in

February, the month when the goods were transferred.

In the second case (Figure 13), the goods are paid for in

advance in January, and manufactured in February. But all

bookkeeping entries are made in March when actual transfer takes

place.

The Income statement

The Income statement (or Profit and Loss statement or

statement of Earnings) reports on the revenues and expenses

~hich have accrued during the accounting period. Normally, the

preceeding year's information is also given for comparison

purposes. Figure 14 sho~s a sample of a carrier statement of

Earnings from an annual report. Like the Balance Sheet sho~

in Figure 11, the major categories follow the civil Aeronautics

Board regulations, but the subaccounts have been condensed and

show less detail than the statements filed with the Board.

- 29 -3JOl

w o

ACCRUAL CONCEPT

JAN.

GOODS MANUFACTURED

Figure 12

FEB. MARCH

GOODS SOLD ON CREDIT CREDIT PAID

/ V

REVENUE ACCOUNTED FOR IN FEBRUARY (ACCRUAL CONCEPT)

l~ EXPENSES ACCOUNTED FOR IN FEBRUARY (MATCHING PRINCIPLE)

Figure 13

ACCRUAL CONCEPT

JAN. FEB. MARCH

CASH PAID IN ADVANCE GOODS MANUFACTURED GOODS DELIVERED

~

~ ~ REVENUE ACCOUNTED FOR

IN MARCH (ACCRUAL CONCEPT)

~ EXPENSES ACCOUNTED FOR IN MARCH (MATCHING PRINCIPLE)

Figure 14

Continental Air Lines, Inc.

Statement of Earnings· Year ended December 31, 1968 with comparative figures for 1967

Operating revenues:

P<'$§enger

Mail

Express , Freight

Excess baggage Aircraft interchange rentals, net,

Charter and contract services, ,

Miscellaneous, net . . . . .

Total operating revenue

Operating expenses:

Flying operations,

Ground operations Maintenance and repairs,

Passenger service

Reservations and sales. Advertising and publicity

General and administrative

Depreciation and amortization

Total operating expenses,

Operating income

Non-operating expenses and income:

Interest expense , , , , , ,

Other, net

.'

Total non-operating expenses and income

Earnings before Federal and State income taxes and extraordinary items,

Federal and State income taxes

Earnings before extraordinary items •

Extraordinary items - gains on major dispositions of flight equipment, less income taxes, $2,329,407

Net earnings , , • • •

Net earnings per share of common stock: Before extraordinary items

Extraordinary items

Total, , . , ,

..

- 32 -

1968 1967

$138,769,984 $107,101,678

2,689,949 2,155,930

713,711 683,806

6,354,749 5,038,256

266,140 178,655

45,200

57,865,758 71,263,689

1,534,240 1,700,627

208,194,591 188,167,841

54,410,014 44,367,712

23,174,429 20,083,117

37,045,607 31,081,921

21,662,004 17,995,883

10,922,710 8,204,667

8,397,102 5,017,587

9,262,464 8,004,931

28,367,869 21,028,121

193,242,199 155,783,939

14,952,392 32,383,902

10,129,202 6,208,524

(275,598) (327,624)

9,853,604 5,880,900

5,098,788 26,503,002

, 966,684 11,572,061

4,132,104 14,930,941

2,376,466

$ 4,132,104 $ 17,307,407

$0.41 $1.49 0,24

$0.41 $1.73

~J5

FUNDS FLOW STATEMENTS

Funds can be defined in general terms as economic values,

or in specific terms as cash. The latter is a subset of the

former. The balance sheet shows the financial position of the firm

at a gross point in time and reflects the firm's investments

(assets) and the claims against it (equities). In general the

assets side of the balance sheet shows how funds have been used,

while the equities side refelcts their source.

The Funds Flow Concept

An understanding of the flow of funds through the business

enterprise is essential to sound financial management and proper

allocation of available resources. The financial manager must

,know where he can obtain funds on the best terms and how to

allocate them within his company to maximize the return on the

investment.

The process of funds flow analysis compares two successive

balance sheets. The differences between individual accounts

shows the flows of funds resulting from management decisions.

Analysis will indicate where management has decided to connect

funds (uses), to liquidate assets (sources), to acquire additional

funds (sources), and to reduce claims against the firm (uses).

- 33 - 3J0

Circulating Capital and Working Capital

Figure 15 shows day to day cycle of funds flow in a company.

Sales are made from inventory. In return, the company receives

either a direct cash payment, or extends credit which is shown

as an addition to Accounts Receivable. In turn, the company

buys supplies to produce more inventory. It makes cash payments

or shows its debts in Accounts payable. Eventually, cash trans

fers occur that close out either Accounts Receivable or payable.

This process is on a continuous state of flux. For some

purposes, it is easier to lump current assets and current liabil

ities and refer to these accounts as the "Circulating Capital"

of the firm. The difference between the current assets and

current liabilities of the firm is referred to as "Working Capital"

and is an important indicator of the firm's ability to meet short

term obligations.

Cash Flow Statement

A Cash Flow Statement is a detailed breakdown of the changes

in Working Capital. In particular, it concentrates on those

transactions that affect the Cash Account. Figure 16 shows these

various transactions grouped as operational transactions that

arise from the day to day business; financial transactions that

raise funds and retire debts; and other transactions. The latter

includes discretionary transactions not necessary to the operation

or regular finances of the firm.

- 34 - ~/7

w U1

CIRCULATING CAPITAL FLOW

-

CASH FLOW

NET SALES

OPERATIONAL

TRANSACTIONS

DECREASE IN ACCOUNTS RECEIVABLE

COSTS OF SALES~

SELLING EXPENSES~ \

GENERAL EXPENSES~ '\ '0----'-

MISCELLANEOUS EXPENSES

INCOME TAXES ----I

DECREASE IN CU R n ENT LIABILITIES

INCREASE IN --_./ INVENTORY

. INCREASE IN ___ J

OTHER CURRENT ASSETS

FINANCIAL

TRANSACTIONS

LONG TERM DEBT SALES

INCOME FROM INVESTMENTS

+ " , ,

INTEREST PAyMENTS .......

RETIREMENT OF--.( LONG TERM DEBT

DECREASE IN LOANS PAYABLE

CAPITAL SURPLUS

CAPITAL---t-l EXPENDITURES

INVESTMENT PURCHASE

OTHER

TRANSACTIONS

+

t"<j H

~ I--' 01

The Funds Flow statement

The Funds Flow Statement concentrates on the sources and

uses of capital in a more aggregate sense. Rather than concen-

trating on fluctuations in working capital, it reflects changes

in long term capital commitments in both the assets and equities

of the firm. Only the net change in working capital over the

accounting period is shown.

Figure 17 shows a typical funds flow statement. Sources

of funds corne from increase in equities, (e.g., issue of new

stock) or decreases in assets (e.g., depreciation). The uses of

funds decrease equities (e.g., retirement of bonds), or increase

assets (e.g., purchase of aircraft). since the dual aspect

concept requires assets and equities to balance, sources must

equal uses, or

Equity Increases + Asset Decreases = Equity Decreases + Asset Increases

Figure 18 diagrams the Funds Flow concept.

- 37 - 3ao

FIGURE 17

ABC INC. FUNDS FLOW STATEMENT

w (Xl

~ 9.:> -

YEAR ENDED JUNE 30, 1972

SOURCES OF FUNDS: NET INCOME ADD BACK: DEPRECIATION FUNDS FROM OPERATIONS CAPITAL STOCK ISSUED BONDS ISSUED

TOTAL FUNDS ACQUIRED

USES OF FUNDS: PURCHASE OF HANGER PURCHASE OF AIRCRAFT RETIREMENT OF BONDS CASH DIVIDENDS PAID NET ADDITION TO WORKING CAPITAL

$ 20,000 6,000

26,000 20,000 10,000

$56,000

$10,000 10,000 10,000 10,000 16,000

$56,000

SCHEDULE OF WORKING CAPITAL CHANGES

1971 1972 INCREASE (DECREASE)

CURRENT ASSETS 100,000 98,000 (2,000) CURRENT LIABILITIES 50,000 32,000 18,000* WORKING CAPITAL $16,000

*NOTE: Since a decrease in liabilities is an increase in working capital, it is shown as an increase and not a decrease as it would on a comparative balance sheet.

SOURCES AND USES OF FUNDS

INTERNAL

I NVESTfV1ENT TAX CREDIT

LEASE

FlmDS

RESEf,lVOIR

EXTERNAL

EQUITY ~ .COMmN STOCI( \ PREFERRED STOCI(I CONVERTIBLE

DEBT

• LONG TERM NOTES • SUBORDI r~ATE DEBENTURES • REVOLVING BANI( CREDIT • EQUI PMENT I ~!ST ALLMENT

LeAr,iS I-' co

Sources and uses of funds can be divided into "internal"

and "external" categories. External transactions affect the

relationships between the firm and other parties. The firm

incurs debt from lenders, it makes payments to its shareholders,

etc. In contrast, internal transactions depend solely on

management decisions and do not affect liability to outside

parties. For example, management can decide to use cash to

purchase assets. This does not affect the external debts of

the firm.

Most categories of Figure 18 are self-explanatory. However,

some need further clarification.

Internal Sources

1. Depreciation and Amortization. Many assets are used for

years after they are paid for. It is common practice to spread the

cost over the entire lifetime rather than show a one-time large

expense. In fact, tax laws require a :tong term write off in

many instances. But, in fact, payment has already been made. So

when depreciation or amortization appears as an expense, it does

not actually represent a funds outlay. So these amounts which

lower accounting income (profits) must be added to other sources

of funds to see how much is actually available for use.

figure 17).

- 40 -

(See

Depreciation refers to the write off of tangible assets

such as flight or group equipment, while Amortization applies

to the write off of intangibles such as pilot training or good

will. Together, depreciation and amortization amount to almost

40% of the total financial resources of major u.s. carriers in

1969.

The straight-line method is used by almost all of the

major U.S. airlines to depreciate their flight equipment for

bookkeeping purposes. The residual value and the period of

depreciation varies within the range of 10-15% and 10-15 years.

Recently some of the carriers have increased the depreciable

life of their flight equipment for several reasons: first, certain

aircraft have longer useful lives than was first assumed; second,

an increase in the depreciable life improves reported earnings

in future years since from an accounting point of view, it costs

the carrier less to provide the same service; and third, the

resulting short term higher profits can be offset against the

carrier's accumulated investment tax credits.

For tax purposes, major airlines use accelerated depreciation

in their accounting for the Internal Revenue Service. A typical

accelerated depreciation is the double declining balance method.

The carriers depreciate their assets over 8 years to a 5% residual

value. During the early years, a greater proportion of the

asset is expended on the books kept for tax purposes than in

- 41 - ~~¥

• f!;ETI10J2~-.9LQ[EJi(C~[\ T 1_9~t ~TRMGHjJJ.i'!LVS._ DOUnLE DECLir,!ING BM.M1Cr;.

REPORTW VALUE OF I\SSETS

DD8

STlll\lGHT LINE

----------------------- .. ------.-- --.-.----.• -.- YCi\n S

those kept for the general operations the stockholders reports,

which use a straight line method. This insures that the income,

as reported to IRS, is lower and hence the taxes actually paid

are less than those stated in the stockholders reports. Later

on, the trend reverses, and more taxes have to be paid than

reported to the stockholders. This eventuality is provided for

by the liability account "deferred taxes." (See figure 19).

Under this system, a carrier has the use of the cash credited to

Deferred Taxes until that cash is actually needed. However,

since fleet acquisition is a continuous process, deferred taxes

are a relatively permanent source of funds for the industry.

In cases where there are no before-tax-profits, or actual

before tax losses, there would be no expense. Consequently

there would be no difference between publicly reported tax

payments and actual IRS tax liability. In this case, therefore,

no deferred tax "source" of funds. Unless there are profits,

there will be no deferred tax "source."

(In the case of an actual loss, there could be a tax loss

credit that could be used to offset future tax liability but

only if and when there are positive earnings.) In addition to

tax and internal depreciation methods, a third scheme is imposed

by the civil Aeronoutics Board for rate-making purposes. When the

Board computes the rate of return on investment, it uses a straight

line method to determine the investment value of the equipment

- 43 -

(owned by the carrier. Table 1 shows the service life and

residual values used by the Board).

2. Investment Tax Credit - The investment tax credit was

initiated in 1962 to provide an incentive for the industry to

modernize its facilities through the purchase of capital equip

ment. Carriers were allowed to claim a tax deduction of up

to 7% of their investment in qualifying property. The qualifica

tions were; first, the property had to be tangible, depreciable

and have a useful life of at least four years; and second, the

property had to be placed in service during the year in which the

tax credit was claimed. The credit is 7% on assets with useful

lives of at least 8 years, 4.7% for assets having useful lives

of 6 to 7 years, and 2.3% for assets with a 4 to 5 year useful

life.

Up until October 10, 1966, when the ITC was suspended for

5 months, the tax deduction could be used to offset tax liability

dollar-for-dollar for the first $25,000, but only at 25¢ to the

dollar above that level. Unused credits could be carried back 3

years and forward five. On March 10, 1967, the, ITC was restored

with expanded provisions. Effective January 1, 1968, the limit

on the amount of tax liability that could be offset above $25,000

was raised from 25 ~o 50 ¢ on the dollar and the carry-forward

period was extended to seven years.

- 44 -

~ 9..:> 0')

>1> lJl

TABLE 1

FLIGHT EQUIPMENT DEPRECIATION AND RESIDUAL VALUES AS SET BY THE CAB FOR RATE-MAKING PURPOSES

SERVICE LIFE IN YEARS

TURBO-FAN EQUIPMENT 4-ENGINE 14 3-ENGlNE 14 2-ENGINE 14

TURBO-JET EQUIPMENT 4-ENGlNE 10 2-ENGINE 10

TURBO-PROP EQUIPMENT 4-ENGINE 12 2-ENGINE 10

WIDE-BODY EQUIPMENT 4-ENGINE 14 3-ENGINE 16

RESIDUAL VALUE AS % OF COST

2 2 2

5 5

5 15

10 10

SOURCE: CAB, "PART 399 - STATEMENTS OF GENERAL POLICY: TREATMENT OF FLIGHT EQUIPMENT DEPRECIATION AND RESIDUAL VALUES FOR RATE PURPOSES," APRIL 9, 1971

There are two options for handling investment tax credits.

The first is the "flow-through" method that allows the entire

amount of the credit to be taken in the year the capital expendi

tures are made. The second is "service-life flow-through" which

reduces the tax liability over the service lives of the related

assets. The first method cencentrates the full effect of the

credit in one year, while the "service-life" method provides

for a more even distribution.

The investment tax credit can only be used if there is tax

liability. Whereas the 25% limitation prevented full utilization

of the ITC before 1966, in recent years the downward trend in

profits has limited its usefulness.

Table 2 summarizes the major internal sources of funds for

the major u. S. carriers, and their amounts.

External Sources

1. Straight Debt - There are four basic types of straight

debt financing employed by the airlines: long-term notes, sub

ordinated debentures, revolving credit and equipment installment

loans.

1.1 Long Term Notes

Senior long term notes are by far the most widely used debt

instruments in the airline industry. They are typically sold to

institutional investors (banks and insurance companies) and have

- 46 -

INTERNAL SOURCES OF FUNDS MAJOR U.S. AIR CARRIERS - 1969

SOURCE

TABLE 2

FUNDS ($MILLIONS)

EARNINGS AFTER TAXES BUT BEFORE ITC 318

DEPRECIATION & AMORTIZATION 808

DEFERRED TAXES 341

INVESTMENT TAX CREDIT 37

TOTAL 1504

PERCENTAGE

21.1

53.7

22.7

2.5

100.0

SOURCE: ATA, "MAJOR U. S. AIRLINES, ECONOMIC REVIEW AND FINANCIAL OUTLOOK", JUNE, 1969

maturities of 20 to 40 years. Some of these notes are secured by

specific equipment pledged as collateral. Holders of unsecured

notes have priority against unpledged assets of the carrier in

case of bankruptcy, but no specific assets are mentioned in the

terms of the loan agreement. All long term notes have indentures

specifying the details to the financial agreement, and any

protective covenants that exist.

1.2. Subordinated Debentures

A subordinated debenture is an unsecured debt. In the event

of liquidation, the holder has a claim on the assets left after

the unsubordinated or seniar debt is satisfied. Banks and

insurance companies supplying senior debt often require sub

ordination of other debts in order to protect their investment.

In contrast to senior debt subordinated debentures are often

sold in the securities markets in comparatively small denomina-

tions ($1000).

1.3. Revolving Credit

Revolving credit loans are short term credit arrangements

between the carrier and bank or group of banks. The financial

source guarantees that it will provide up to some amount of

dollars to the carrier on demand. In return, the carrier may pay

a basic service charge, or more often, a premium rate for the

funds it actually uses.

- 48 -

1.4. Equipment Installment Loans

Equipment installment loans are similar to automobile

financing arrangements. They provide the smallest contribution

to the air carriers' debt. These notes represent the willingness

of the various manufacturers to participate in the financing of

equipment orders and are usually secured by the equipment purchased.

2. Equity - In equity financing, the carrier sells additional

shares in its own ownership through the issuance of preferred or

common stock.

2.1. Preferred Stock

Preferred stockholders usually have the first option on

dividends when available, and a preference over the common share

holders if the company is liquidated. The disadvantages of

holding preferred stocks are first, that the dividend, when paid,

is usually fixed and not proportional to corporate profits: and

second, that the preferred stock usually has no voting rights.

Unlike interest payments on debt, preferred stock dividends

are not deductable from income before taxes which is one reason

that it is seldom used by airlines today.

2.2. Common stock

Common stock offers many advantages as a source of funds.

First, there are no fixed charges, interest or dividends that

- 49 -

must be paid. Second, there is no maturity date when the

debt must be retired. Third, common stock provides an "equity

cushion" against losses for senior creditors since it is sub

ordinate to their claims. Fourth, common stock may be more

appealing than bonds to certain investor groups, since it has

the potential of high dividends and rapid appreciation if the

company is successful.

The disadvantages are that a new issue of common stock

further divides ownership in the airline. Second, the new owners

expect to share in the profits, which can put pressure on manage

ment to reduce retained earnings by dividend payments. Third,

the cost of underwriting and distribution common stock is usually

higher than for an equal dollar amount of bonds. Finally, like

preferred stock, dividends paid are not deductible from pre-tax

income.

3. Convertible Debt - A convertible debenture is a hybrid

security having characteristics of both straight debt and common

equity. It is issued as a subordinate debenture carrying a fixed

interest provision. In addition, the holder is given the option

of converting his debenture into a specified number of shares of

the airline's common stock at a specified price (usually consider

ably above the present market price of the common stock). Because

- 50 -

of the conversion privilege with its potential for capital

appreciation, the bond carries a lower interest rate than compar-

able straight debt obligations. (see Table 3). On the other

hand, convertible debentures provide greater present income and

security than common stock.

The airlines have found this type of financing very attractive.

since the debenture is a debt,interest payments are tax deductable

until the bond is converted. Because of the conversion privilege,

the airline can get a lower interest rate than if it were forced

to use straight debt financing. And once conversion takes place,

the carrier's obligation to pay interest and repay principle is

over. The book value is shifted to the common equity account,

reducing the carrier's debt/equity ratio which improves the chances

of further borrowing on more favorable terms.

4. Investment Tax Credit Lease - A financial intermediary

with a high marginal tax rate (usually a large commercial bank or

a group of wealthy investors) purchases an aircraft and simultane-

ously leases it on a long term basis to an airline. Normally the

intermediary itself provides only 20% of the aircraft's purchase

price selling equipment trust certificates to finance the remaining

80%. In the event of default, the equipment trust certificates are

secured by the aircraft in question which can be repossessed by

the certificate holders. They do not have a claim against the

- 51 -

V1 tv

TABLE 3

COST OF EMBEDDED DEBT CAPITAL AS OF 12/31/69 (%)

AA EA 'IW UA

DL NW CO NA

CONVERTIBLE

4.68 5.07 4.71 4.70

-0--0-3.63 6.00

NONCOVERTIBLE

5.06 6.04 6.08 5.93

7.99 6.97 5.87 6.90

TOTAL

4.90 5.84 5.62 5.61

7.99 6.97 5.48 6.90

SOURCE: CAB DOCKET 21866-8, "DOMESTIC PASSENGER-FARE INVESTIGATIONRATE OF RETURN," APRIL 9, 1971.

financial intermediary under these circumstances. Generally

the trust certificates are purchased by a syndicate of life

insurance companies or in some cases, a bank or a group of

banks will simply pay the full price of the aircraft without

creating the equipment trust at all.

By leasing the aircraft, the air carrier usually pays a

lower effective interest rate. The rental payments need only

cover the repayment (interest + principal) of the equipment

trust certificates, which represent only 80% of the cost of the

aircraft. (However, the airline has no claim to any residual

value at the end of the lease). The intermediary, being the

legal owner of the aircraft, receives the full investment tax

credit and depreciation tax shield in return for his 20% invest

ment. In addition, he gets title to the aircraft at the end of

the lease, although the airline often has the option to purchase

the airplane for its residual value.

Table 4 summarizes the major external sources of funds for

the major U. S. carriers and their amounts, while Table 5 shows

the capital structure of several specific airlines.

- 53 -

Ln

""

~ ~ -.l

EXTERNAL SOURCES OF FUNDS MAJOR U.S. AIR CARRIERS - 1969

SENIOR DEBT

REVOLVING CREDIT

AVAIV.BLE 1710.0 USED 503.2

STRAIGHT SUBORDINATED DEBT

EQUIPMENT NOTES

CONVERTIBLE SUBORDINATED NOTES

TABLE; 4

ESTIMATED CAPITAL VALUE OF LEASED AIRCRAFT

TOTAL IMpUTI.'.:D DI.'.:BT

~ PERCENTAGE

2626.6 39.3

503.2 7.5

153.3 2.3

108.7 1.6

1484.4 22.2

1806.9 27.0

6683.;1. 100.0

U1 U1

W W OQ

TABLE 5

COMPONENTS OF CAPITAL STRUCTURE AS OF 12/31/69 (MILLIONS OF $)

TOTAL BOOK DEBT EQUITY CONVERTIBLE NONCONVERTIBLE

AA 403.3 282.8 398.4 EA 225.0 127.4 498.7 TW 361.8 250.0 507.2 UA 588.1 230.2 649.9

DL 241.4 -0- 236.3 NW 426.8 -0- 112.0 CO 96.3 35.0 164.8 NA 130.5 0.5 65.7

SOURCE: CAB DOCKET 21866-8. "DOMESTIC PASSENGER-FARE RATE OF RETURN." APRIL 9. 1971.

COMPONENTS OF CAPITAL STRUCTURE AS OF 12/31/69 (%)

TOTAL BOOK DEBT EQUITY CONVERTIBLE NONCONVERTIBLE

AA 37.2 26.1 36.7 EA 26.4 15.0 58.6 TW 32.3 22.3 45.7 UA 40.1 15.7 44.2

DL 50.5 -0- 49.5 NW 79.2 -0- 20.8 CO 32.5 11.8 55.7 NA 66.3 0.3 33.4

TOTAL TOTAL CAPITAL

681.2 1084.5 626.1 851.1 757.2 1119.0 880.1 1468.2

236.3 477.7 112.0 538.8 199.8 296.1 66.2 196.7

INVESTIGATION-

TOTAL

62.8 73.6 67.7 59.9

49.5 20.8 67.5 33.7

SOURCE: CAB DOCKET 21866-8. "DOMESTIC PASSENGER-FARE INVESTIGATION- RATE OF RETURN". APRIL 9. 1971

FINANCIAL RATIOS

The various financial statements discussed contain a great

deal of information. A large amount of additional information

can be gained by studying the relationships between the items

in the basic statements. Financial analysts often find that

these relationships are best expressed as ratios which provide

additional insight into the operations of the firm. Ratios can

also provide a method of quick analysis that isolates a problem

area for further study.

Any ratio in itself is meaningless. There must be a standard

of comparison. Often these standards are based on the historical

trends of the firm. Often the performance of competing firms

can be used. Other standards can be derived from industry

performance, or performance of the economy as a whole. Another

valuable source of comparison comes from the general background

and experience of the analyst and his feelings for what various

financial ratios ought to be.

Although innumerable ratios could be formed from the various

items on the financial statements, several of particular value have

been standardized through usage and experience. In general, these

can be grouped into those that are useful in making short term

financial decisions, long term financial decision and investment

decisions. Ratios may also be an aide in evaluating management

performance or market performance of a firm's stock.

- 56 -

Short Term

Before a financial source makes a short term loan, it must

determine the liquidity of the firm - its ability to repay on a

short term basis. The lender is not concerned with the overall

assets of the firm, but with its ability to pay its bills without

liquidating long term holdings. Some of the ratios commonly used

to evaluate debt paying ability to potential creditors are:

1. Current ratio - The current ratio is a very rough measure

of the ability to meet short term obligations. It is defined as

current assets divided by current liabilities. As a rule of thumb

for industry on the average, a healthy firm should have a current

ratio of about 2 to 1. However, industries with a large fixed

investment like utilities or hotels have satisfactory working

capital at a current ratio of 1. The airlines typically have a

current ratio of 1.2 to 1.5.

2. Acid Test Rati. 0 - Since current assets include monitories

which may be hard to sell in an emergency, the current ratio may

not really reflect liquidity. The acid test ratio is often used

as a better measure. It is defined as current assets minus

monitories, divided by current liabilities. For an airline, it

would be computed on the basis of current assets minus spare parts

and supplies, and might run between.S and 1.

- 57 -

3. Cash and Eguivalent Ratio - This ratio only compares cash

on hand and assets quickly convertable to cash (such as government

securities) to current liabilities. This may be too extreme a

measure of ability to repay a short term obligation since it is

doubtful that all current liabilities would fall due at once. For

an airline. this ratio might typically fall between .3 and .5.

Long Term

An investor who considers purchasing a long term obligation

from an airline is not as concerned with liquidity as he is with

his overall security. This is typically measured by the Debt

Ratio. long term debt divided by stockholders equity. Table 6

shows typical debt ratios for the airlines and for other trans

portation firms. In general. the lower the ratio. the more secure

the investment.

Investment

Investment in this context is the original purchase of stock

holder's equity in the firm. contrasted with market transactions

between stockholders. It applies to original issues only. In

deciding whether or not to buy a new stock. the investor is

concerned with the potential rate of return. and the risk involved.

Rate of return is a ratio of net income to total equity - that

is. liabilities plus stockholder's equity. Tables 7 and 8 show

- 58 -

TABLE 6

LONG-TERM DEBT/TOTAL STOCKHOLDER'S EQUITY FOR 1969

INDUSTRY

AIRLINES: ALL TRUNKLlNES B!G 4 (AA,EA,TW,UA) LITTLE 4 (CO,DL,NA,NW)

TRUCKING: CONSOLIDATED FREIGHTWAYS McLEAN TRUCKING COMPANY

RAILROADS: PENN CENTRAL TRANSPORTATION COMPANY CHESAPEAKE AND OHIO RAILWAY COMPANY

BUSSING:

RATIO

1.50 1.B7 0.69

1.04 0.92

0.59 0.27

GREYHOUND 0.B3

SOURCE: MOODY'S TRANSPORTATION MANUAL (NEW YORK, 1971) CAB

TABLE 7

RATES OF RETURN ON INVESTMENT (CAB)

, J

i i I i , TOTAL TRUNKS. ! I DOMESTIC i

, ! BIG 4. i ! DOMESTIC

I

i i OTHER TRUNKS. I

DOMESTIC i I

.

! I ,

1970 1969

1.07%, 5.28% , , ,

-1.58 '4.87

5.72 i

6.05

1968

5.67%

3.84

9.92

1967

i " 8.85% ! !

7.35

i , 112.74 I , , i

,

1966

10.36%

7.48

17.58

1965 ! 1964 1963 1962

II " I I ' 12.04% I' 9.62% \ 4.20%: 4.10% i

, i

! II 9.76 \ 7.79 I 2.97

i

118.50 I !

I I i 15.10 \ 7.74

i i i I , I

2.66

8.48

1961 I ,

1.46%

i 1. 32 1

1. 92

PASS. /CARGO. INT'L & TERR. 2.58 4.42

i :14.21

i !16.28

! I

1 I I

3.14

1

10.82! 15.02 i13.29 ! 13.11 .8.69

i' I ________________ ~, ______________ ~ _______ I~ ____ ~ ______ ~i ______ ~:------~,------~,--____ ~ __ _

TABLE 8

RETURN ON INVESTED CAPITAL FOR THE 500 LARGEST INDUSTRIAL CORPORATIONS (INDUSTRY MEDIANS)

1968

PHARMACEUTICALS ...........•.•..•................. 17.9% SOAPS, COSMETICS .............................•.•. 16.9 MINING .............•..••..........•...........•.. 16.8 DOMESTIC TRUNKLINES * ............................. 10.0 TABACCO ...............••.•..•.................•.• 14. 7 PUBLISHING, PRINTING •......•.•.•...............•. 14.1 APPAREL •...•................•....•............... 13.0 MEASURING, SCIENTIFIC, PHOTOGRAPHIC EQUIPMENT .... 13.0 METAL PRODUCTS •.................•.•.............. 12.4 AIRCRAFT AND PARTS ......................•..•..... 12.2 FARM, INDUSTRIAL MACHINERy .............•.•....... 12.2 FOOD AND BEVERAGE .......................•........ 12.1 SHIPBUILDING AND RAILROAD EQUIPMENT •.•..•........ 12.0 PETROLEUM REFINING .............................•. 11.8 APPLIANCES, ELECTRONICS .........•................ 11.7 MOTOR VEHICLES AND PARTS •....................•••. 11.6 OFFICE MACHINERY (INCLUDES COMPUTERS) .......•.... 11.3 RUBBER ..................•.......................• 11.3 PAPER AND WOOD PRODUCTS ...•.••..................• 10.0 METAL MANUFACTURING .............................• 9.9 CHEMICALS. . • . . . . . . . . . • . . . • • . . . . . . • . • • . • . . . . . . . . . . . 9.7 GLASS, CEMENT, GYPSUM, CONCRETE ........•.•..•.... 8.7 TEXTILES •...•...........•.••...........•......... 8.3

ALL INDUSTRY 11. 7

* APPROXIMATE VALUES

1967

18.0% 15.9 16.4 15.0 13 .4 12.5 12.3 14.3 13.0 12.0 12.0 10.0 10.5 11. 2 11.6 10.4 14.2

9.1 9.0 8.8

10.0 8.3 7.2

11. 3

SOURCE: "THE FORTUNE DIRECTORY OF THE 500 LARGEST INDUSTRIAL CORPORATIONS," FORTUNE, 1968, 1969

1966

18.4% 15.7 16.2 20.0 13.2 14.8 14.5 14.7 13.3 14.8 14.5 11.1 12.6 12.3 13.3 14.3 14.0 11. 2 10.4 10.8 12.6 11.0 11.4

12.7

rates of return for airlines and for various other industries

over a several year period. An investor would be interested in

both the trend and size of returns in the firm he is considering

as well as what would be available to him from other firms in

the sarne or other industries.

The mixture of debt and equity financing is very important

in deterrning the risk. This is measured by the Debt Ratio

previously mentioned. The ratio of debt to stockholder's equity

determines the leverage of the firm. Leverage involves the use

of borrowed funds in expectation that the earned rate of return

will be higher than the cost of those funds.

Table 9 shows the effect of different debt ratios on the

stockholder's return on investment. In all cases, a total invest

ment of $1,000,000 and a 1~1o cost of servicing the debt is

assumed. The higher the debt ratio, the more sensitive 1S the

stockholder's return to the overall rate of return of the firm.

Hanagement performance Ratios

Financial ratios can be used to compare the effectiveness of

management. The better the management, the more profits it can

make on the investment and the lower the expenses with respect to

revenues. Table 10 shows some of the ratios used to evaluate

management performance and some typical values for the airline

industry.

- 62 -

(l'l

w

Il.>v

~

TOTAL INVESTMENT

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

TABLE 9

LEVERAGE EXAMPLE

DEBTl

, I

jSHAREHOLDERS RATIO DEBT I EQUITY

I

! ,

1 $500,000\ $500,000

1 $500,000 $500,000

1 $500,000 $500,000 I I

I I ! I $750,0001 $250,000 3 I 1

3 $750,0001 $250,000 I I

3 $750,000i $250,000

I I I

1.5 $600,000 $400,000

1.5 $600,000· $400,000

I 1.5 $600,000 $400,000 ,

,

RATE OF RETURN

12% ,

15% i , , !

7.5% i I I i

, !

12% i I ,

15% I , , i

7.5% i

,

12% , I

15% I

l I

7.5%

I

NET I

! I INCOME INTEREST i NET \RETURN ON BEFORE (at 10%) i INCOME i STOCKHOLDERS

i ,

INTEREST i I

EQUITY

I I ! $120,000: $50,000

, $70,000\ 14% !

I I i i

$150,000 I $50,000 , I ! $100, 000 I 20%

I , I

$ 75,000 • $50,000 i

$25,000 5% , , ! ,

I , ! i

$120,000 $75,000 I $45,000 18% ! I

$150,000 $75,000 1 $75,000 I 30% I I

$ 75,000 $75,000 ' ' ; - 0 - \ 0%

I I , I , ,

$120,000 $60,000 i I 15% i $60,000\ ,

$150,000 :$60,000 $90,000 I 22.5% ,

$ 75,000 1$60,000 $15,000 'I 3.75% !

I I

i ----~. L

TABLE 10

MANAGEMENT PERFORMANCE RATIOS (1968)

INDUSTRY BIG 4 (AA, EA, TW, UA)

OPERATING REVENUES TURNOVER = ---------------------- (%) 60.9% 59.5%

GROSS ASSETS

OPERATING EXPENSE (%) 91. 2"10 94.5%

OPERATING REVENUE

SOURCE = AIRLINE INDUSTRY DATA: DOUGLAS AIRCRAFT CO. SEPT. 1968

LITTLE 4 (CO,DL,NA,NW)

63.9%

82.3%

Internal Rate of Return

When management plans a financial investment, it has

traditionally evaluated the potential rate of return on the

investment base. This process can be confusing, however,

particularly where the useful life of the investment and its

depreciation period are not the same. As an alternative, air-

lines are starting to use the "Internal Rate of Return" method to

evaluate investment alternatives. This method is based on

discounted cash flows and not on the investment base, depreciation,

etc.

If Ao is the initial investment, and Ai is the expected net

cash flow, in or out during the ith time period, the equation

can be formulated as:

Ao = (l+r) Al + A2 + ... + An

-,---=-:--(l+r) (l+r)n

r then represents the rate of return on the initial

investment, Ao, earned from the future total cash flow

discounted over the appropriate time periods. By comparing the

various internal rates of return that can be expected from

different investment strategies, the firm can decide which project

offers the best return on the money presently available.

- 65 -

Market Performance Ratios

Market performance is important when one purchases stock in

the market from a prior stockholder, rather than from the company

itself as part of an initial stock issue. The market investor is

concerned with the health of the company whose stock he is buying.

But he is also interested in how the stock compares with other

stocks he might purchase in the market place.

1. Earnings Per Share - this is the ratio of the net income

of the firm to the number of shares outstanding and gives some

measure of the worth and earning power of the stock.

2. Price-Earnings Ratio - The market price of the stock is

divided by the earnings per share as computed above. This relates

the earning power of the stock to how much it costs.

3. Yield (Dividend yield) - To determine the return on his

investment, the stockholder is not only interested in how large a

dividend is paid on a share, but how much the share costs. Yield

is defined as dividends per share divided by the price per share

and represents the percentage return on investment in the stock.

- 66 -

BASIC FINANCE Joseph Vittek

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